Home Retail Group Plcs External Audit - Risk-Based Approach - Example

Home Retail Group plc External Audit: Risk-based approach ISA 315 “Understanding an entity and its environment” is the auditing standard which requires the external auditor to acquire relevant understanding of various financial and non-financial aspects that surrounds an entity. This primarily includes obtaining an understanding of the accounting framework applicable on the financial reporting of the entity, the applicable regulatory requirements, competitive business environment, socio economical and political environment, implementation of internal control in the entity etc. Keeping these factors in to consideration, the auditor places a risk assessment procedure and identifies the entity’s level of vulnerability towards business risks. Once the risk assessment is done, the auditor then devises audit procedures in order to address those risks and minimise them to the greatest extent. Home Retail Group plc are broadly divided into two business segments Argos and Homebase. This group sells a variety of products which include garden and household items, furniture, office equipment, toys, games, etc. These items can be categorised as luxury items and are not considered basic products which people would be able to survive without, like food and clothes. Therefore, in a recession time these types of business are the ones that are hit the hardest. A brief analysis of the historical share price movement of the company will further corroborate the fact that during the global financial recession of 2008 the share price of the company took a sharp downward plunge. Thus there’s a risk that in the time of financial crisis the company will try to inflate its earnings in order to make its financial position look more stable. Other risk assessment procedure through which the business risk can be identified is determining who the major customers are of Home retail Group. For the financial year end 2011, the company had receivables amounting to £ 610.3million which constitutes around 14.7% of the total assets. Thus, there involves a business risk that if the debtors of the company defaults there is a chance that the company might have to face going concern issues. Further more, in order to identify the business risk, the industry wise data can also be analysed. Home retail group operates in the retail consumer industry which is considered to be the most competitive market. A risk assessment procedure could be the financial analysis of the competitors of Home Retail in order to identify the basic ratios of the competitors and comparing it with the relevant financial ratios of Home Retail. This will assist the external auditor in identifying whether the company is performing below, above or at par as compared to its competitors. For example if the gross profit margin of Home Retail Group is significantly higher than its competitors than there is a chance that the company has overstated its revenues in order to portray sound financial outlook. For this particular risk assessment procedure audit evidence can be obtained from the financial statement of the competitors and overall industry performance data can be extracted from the Securities and Exchange Commission website. ISA 315 also requires the auditor to obtain an understanding of the legal environment in which the entity operates and of the applicable laws and regulations. Since Home Retail is a UK based company, the auditors should obtain an adequate understanding of the company law to ensure that the company complies with the relevant laws. Non-compliance with the applicable statute can results into significant penalties and in certain cases a total ban on the company. Such situation can cause a significant impact on the ability of the company to continue as a going concern. In addition, auditors should also conduct meetings with the legal advisor of the company in order to identify significant contingencies which could have a significant impact on the financial position of the company. The external auditor in all circumstances must obtain an understanding of the internal control environment of the company. Strong internal control environment reflects that the company’s operations are running effectively and in accordance with the standard operating procedures. Strong controls also enable the auditors to put less reliance on ‘Test of details’ and obtain reasonable assurance on the financial statements of the company through ‘Control Testing’. 2-Going concern problems The purpose of this report is to make an analysis and compare Home Retail Group’s financial statements for three years, from 2009 to 2011. Firstly, the profitability ration’s shows that the profit margin has sharply decreased in 2009, reaching -6.68%, the lowest recorded in those 3 years when compare to 4.87% in 2010 and 4.53% in 2011. The reasons behind those significant changes could have been the worldwide recession, which has affected most of business around the world. In 2010 the company shows recovery, however in 2011 the profit margin started to go down again. This can be explained as for every £1 that the business makes, its profit (before tax) has been reduced by 0.34% on those two years. Consequently, this fall put the company in a very difficult situation to compete pricewise in a similar market. The sharp increase in the profit margin from the financial year 2009 to financial year 2010 indicates a significant risk. There is the risk involved that the company has overstated its earnings in order to portray stable financial outlook and boost the shareholder’s confidence in them. In addition to this, the ROCE (return on capital employed) has also been sharply reduced to -11.01% in 2009 and had a significant increase in 2010 reaching 10.61%, despite start to fall again in 2011 by 0.16% . This means the investors would get 0.16 pence lesser return on every £1 invested in the business compared to one year earlier. ROCE shows that the money invested is not working harder when compared year to year. A brief analysis of the financial year end 2010 would reveal the fact that the financial position of the company was stabilizing. However the following financial year, 2011, it appeared that the investors lot their credibility in the business and started raising the going concern risk. As it is apparent from the article in the Daily Telegraph “Home Retail shares fell 4.25 to 83.00p as the group said like-for-like sales at Argos fall 8.8pc in the 18 weeks to the end of December. Gross profit margins were down 0.5 percentage points, driven by higher shipping rates and discounting, with total Argos sales down by 7.8pc to £1.7bn.”(Daily Telegraph/ January 13, 2012 Friday). 5.75 6.44 6.34 5.75 6.44 6.34 In addition, the analysis of financial management ratios also gives an idea about how the company is managing its current assets in order to provide funds to keep up to date with its short-term liabilities. For example, the analysis of quick asset ratio shows that in 2009 Home Retail Group had 0.86 pence to pay off for every £1 of debt (liability). It is followed by a rise in quick assets ratio for 2010 of 0.15, despite decline again in the following year; reaching 0.79. It must be noted that a current asset ratio of 1:1 is considered to be acceptable for such typical trading company. In addition to this, the debt equity ratio is another measure of how well the company is operating in the sector and how much it is relying on the funds generated through the operations rather than the borrowed funds. Increase in debt equity percentage shows that the company has acquired more debts (liabilities from last period). Whereas decrease shows that the business has managed to reduced its debts and have less insolvency risk exposure. A significant declined in the gearing ratios since 2009 has bee noted from 12.16% to 10.14% in 2011. This is considered a positive outocme as the results indicates that the company is trying to reduce its debt funding and rely more on capital funding. This consequently decreases the inherent and control risk relating to interest charges issues and high level of long term liabilities. In addition to the above, comparing inventory ratios with previous years indicates that the stock turnover level has changed considerably from 6.44 in 2010 to 5.75 in 2011. This reduction indicates that the entity is overstocking. This could have been caused by the inability to sell, too much competition, recession, obsolete products or error in the stock records. As a consequence, it increases the storage space costs and the corresponding audit risk. The fact which requires consideration is that the credit period has increased from 29 days in 2009 to 30 in the next two years. This change could also be one of the reasons due to overstocking. The previously mentioned issues points out another audit risk which is the understatement of provision of slow moving stock. If the company’s has overstocking some of these stocks will required to be written off. There is an adequate chance that the company is not able to record adequate provision against these obsolete items. Taking everything into account, we can conclude that the globalised recession had a huge impact on business worldwide. As a consequence, many of them which were unable to maintain in business were declared bankruptcy. On this instance, Home Retail Group plc seems to be in a delicate financial position, increasing the audit risk. Those risks could be misstatement of financial statement by error or fraud in order to survive in this very competitive market. In addition, as an external auditor the going concern problem should be analysed taking in consideration many factors. Those factors are economic situation, competition, industry and a close analysis of the previous and future financial statements. 3-Qualitative factors Home retail group is having a very difficult financial period since 2009 when the worldwide recession started. Based on the analysis of the financial statement for these three years, there is a doubt about the companies’ ability to continuing on business. However, there are some qualitative factors and information about the company which indicate they may be able recovers from these financial difficulties. The group has stated in 2011 annual report that they will keep investing in multi-channel retail and project yielding innovation. These investments strategy intends to increase their monthly sale figures and gain new customers and is proving to be a successful approach as the company has said that the multi-channel sales has gone up to £1.9bn representing 46% of its total sales. The new and revised strategy also shows that the stores refurbishment play a big part on the sales improvements. Furthermore, net cash position of £259m and reduction in operation and administrative cost by £60m can also be considered a very positive result. This is because assets liquidity on a business environment is considered a sign of financial strengths and a very low cash flow could be seen as going concern problem. We live in technological era where the internet business is growing in a very fast speed. This change has taken place in almost all companies around the world. In order to be competitive today and in the future, Home retail group has been investing in technology and internet business. These improvements has helped the company to position themselves as the second largest internet retail in UK, counting 36% of Argos total sales. All those points mention above put the group in a stronger position to keep in business and be competitive for the future. Another factor which would increase this assurance is how seriously the company is committed towards the implementation of its internal control. The audit committee report shows that they have a very strong system in place to monitor, detect and evaluate the risks. Subsequently, providing enough information to amend or make changes where necessary. The audit committee is responsible to test how efficiently these procedures are implemented and they report regularly to the board. In addition, the group make sure any important decisions are dealt by the appointed and authorized personnel. The company also have a very good channel of communication with the shareholders. All those factors point towards the fact that the company is expected to have a stronger business position in the future. 4-External Auditor opinion UK version of ISA 700 requires the auditor to give an opinion on the Financial Statement taken as a whole, give a true and fair view. Based on evidence whether financial statements are free from material misstatement due to error or fraud. It also requires the external auditor to analysis if it has been prepared in accordance with applicable financial reporting framework and complies with the relevant law. When the external auditor of a company concludes that the financial statement are prepared in accordance with the applicable financial reporting framework and represents a true and fair view, they issue an unqualified or clean audit report. ISA 705 ‘modifications to the audit report’ requires the auditor to modify the audit report when the auditor identifies that the financial statement are not free from material misstatement and the auditor is unable to obtain sufficient appropriate audit evidence on which to base the audit opinion. The modification to the audit report is further explained through the following table. Nature of Matter Giving Rise to the Modification Auditors Judgment about the pervasiveness of the Effects or Possible Effects on the Financial Statement Material but Not Pervasive Material and Pervasive Financial statements are materially misstated Qualified Opinion Adverse Opinion Inability to obtain sufficient appropriate audit evidence Qualified Opinion Disclaimer of Opinion ISA 706 ‘Emphasis of matter paragraph’ requires the external auditor to include an emphasis of matter paragraph in the audit report when the auditor feels the need to draw the attention of the user towards a significant financial matter which is disclosed elsewhere in the financial statements. An example of situation in which the auditor would include an emphasis of matter paragraph where the company in involved in major litigation and if the outcome of the litigation is not in the favour of the company, the company could face serious going concern issues. In this situation the order would not modify the audit report, rather it will include an emphasis of matter paragraph in the audit report pointing towards the fact that the company is at present facing a serious litigation and will provide the necessary details. The Audit report’s requires having the following; Title, addressee, introductory Paragraph, respective responsibilities of those charged with governance and auditors, scope of the audit of the financial statements, opinion on the financial statements, opinion in respect of an additional financial reporting framework, requirement specific to public sector entities where an opinion on regularity is given, opinion on other matters, date of report, location of auditor’s office, auditor’s signature. Based on the financial analysis of Home retail Group, the company does not have any contingent liability as disclosed in the note 31 of the financial statement of the company which states that if although there are a number of contingent liability faced by the company not any of them results in the material outflow from the company. In addition, though the company has been facing financial difficulty during the current financial year, but the forecasts and projection shows that it has the capability and tenacity to continue as a going concern in the future. Thus, the auditor report of Home Retail Group for the financial year end 2011 should be unqualified. Biography: - Auditing & Assurance Services by Aasmund Eilifsen, William F. Messier Jr, Steven M. Glover & Douglas F. Prawitt -The daily Telegraph/ January 13, 2012 Friday -Auditing: an international approach  By Bahram Soltani -The Business Environment by Ian Brooks and Jamie Weatherson, second edition. - ISA 315 - ISA 700 - The Audit Process by Ian Gray & Stuart Manson/ 4th edition -Risk-Based Auditing by Phill Griffiths/ 2005 - Auditing/ A business Risk Approach by Rittenberg, Schwieger and Johnstone/ sixth edition. - Home Retail Group plc -http://www.reuters.com/article/2012/01/12/homeretail-idusl6e8cb4qi20120112?Type=companynews -http://tools.morningstar.co.uk/uk/stockreport/default.aspx?tab=11&SecurityToken=0P000090SU]3]0]E0GBR$$ALL&Id=0P000090SU&ClientFund=0&CurrencyId=GBP Read More